Category: SEC News

Elon Musk and the SEC Move Fast

On August 7, 2018, Elon Musk, the CEO of Tesla, tweeted to his 22 million Twitter followers that he could take Tesla private at $420 per share. There turned out to be little to no truth behind that public announcement. Regardless, Tesla’s stock price rose 6% on increased volume.

It took only a month and half for the SEC to bring its case against him. The SEC announced the filing of an enforcement action against Musk because:

Musk’s false and misleading public statements and omissions caused significant confusion and disruption in the market for Tesla’s stock and resulting harm to investors.

The SEC’s complaint alleges that Musk hadn’t discussed specific deal terms with any potential financing partners. He did have some discussions, but none about price.

“Taking care to provide truthful and accurate information is among a CEO’s most critical obligations.” – Stephanie Avakian, Co-Director of the SEC’s Enforcement Division.

It seems clear that Musk screwed up. It’s not clear that he did so for his own financial gain. If he had sold a bunch of stock right after the Tweet, it’s likely the Department of Justice would be involved and bringing criminal charges. The SEC complaint does ask for disgorgement and civil penalties. Elon has cash, so he can find the likely penalty in his couch cushions.

But the big claim for relief is to bar Musk from “acting as an officer or director of any issuer that has a class of securities registered pursuant to Section 12 of the Exchange Act or that is required to file reports pursuant to Section 15(d) of the Exchange Act.” That means no more CEO of Tesla.

There are few CEOs who are more closely identified with their companies that Musk and Tesla. We had Gates and Microsoft, and Jobs and Apple. I suppose Buffett and Berkshire-Hathaway are there.

I don’t know much about Tesla and don’t know if there is a bench of talent to fill in. The market doesn’t think so. The stock went down sharply after the charges were filed. It dropped 13% losing over $7 billion in shareholder value.

Just as quickly, Musk decided to settle with the SEC rather spend his time distracted by a lengthy battle. After all, there was no allegation of profit-making or conspiracy to manipulate. It was just a stupid off-the-cuff statement.  Rumor has it that Musk was close to settling last week, but pulled out and decided to fight. The market’s reaction over the weekend must have made him reconsider.

The SEC settled for Musk relinquishing his Chairman role, but he can stay on as CEO. The Chairman must be independent and the board must add two additional independent directors. That seems like some better corporate governance.

The SEC required a new committee of independent directors to put in place a additional controls and procedures to oversee Musk’s communications. On November 5, 2013, Tesla filed a Form 8-K disclosing that Musk’s Twitter account would be used to disseminate material information about the company.

To sum things up, the SEC imposed better governance on Tesla and pulled Musk’s Twitter privileges. That’s a good thing. The CEO should not have unfettered communication privileges with the public. You need accuracy and truth in corporate communication. Musk’s Twitter account was labeled as official corporate communication.

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SEC Reminds Us that Guidance Is Not Binding

The Trump Administration’s attack on regulations just made a sweep through the financial industry. The Securities and Exchange Commission, The Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, National Credit Union Administration, and Office of the Comptroller of the Currency all clarified that staff guidance is not a regulation.

SEC Chairman Clayton made it clear that the SEC’s “longstanding position is that all staff statements are nonbinding and create no enforceable legal rights or obligations of the Commission or other parties.” He makes it clear that to have the power of law, there needs to be a published rulemaking in the Federal Register, and adoption of a final rule which considers public comments on the proposal to be in accordance with the Administrative Procedure Act.

I think this cuts both ways. Some guidance creates an additional regulatory burden. But sometimes it clarifies the application of a rule to lessen the regulatory burden.

The banking regulators will focus on making sure that bank examiners will not criticize a supervised financial institution for a “violation” of supervisory guidance. That is clearly falling on the case of regulation by guidance. It does not address the opposite position where a party is complying with the guidance, but the regulators still bring an action.

The SEC enforcement tends to throw everything they don’t like under the vagaries of Section 206 as a fraudulent, deceptive or manipulative act. Take a look at tomorrow’s story for one of those.

I generally think of SEC guidance for investment advisers as a mixed bag. For me, it mostly helps reduce the regulatory burden. It certainly helps craft my thoughts about how to comply with the formal regulations, particularly where the regulation is unclear on a the particular application.

Certainly, there is grumbling about regulation by examination. I’m not sure if this statement from he Chairman will reach to that.

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First Full Day of a Full Strength SEC

Yesterday, the Senate voted to confirm the nomination of Elad L. Roisman to be a member of the Securities and Exchange Commission. Mr. Roisman fills the vacant seat left by Michael Piwowar. This is the fourth Commissioner appointed by President Trump. I expect we will see pictures of the swearing in ceremony this morning.

Mr. Roisman was the chief counsel of the Senate Banking Committee. Before joining the Banking Committee, Roisman was counsel to former SEC Commissioner Daniel Gallagher.

Mr. Roisman will join Republican Commissioner Peirce and Chairman Clayton to likely bring a more de-regulatory stance to the agency

Commissioner Piwowar left the SEC in July and joined the Milken Institute on Wednesday.

The days of a full strength SEC may not last into 2019. Commissioner Stein is serving beyond her term and must step down at the end of the year. There seems to be little incentive for President Trump to speedily re-fill that Democratic spot.

If your wondering who the 15 Nay votes on the confirmation, they are the Senators you would expect.

NAYs —14
Baldwin (D-WI)
Blumenthal (D-CT)
Booker (D-NJ)
Durbin (D-IL)
Feinstein (D-CA)
Gillibrand (D-NY)
Harris (D-CA)
Markey (D-MA)
Menendez (D-NJ)
Merkley (D-OR)
Sanders (I-VT)
Schumer (D-NY)
Warren (D-MA)
Whitehouse (D-RI)

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The One with Bookrunning in Exchange for Not Removing a Platform

Merrill Lynch has lots of relationships and is trying to manage an advisory business, a brokerage business and an investment banking business. It got into trouble for letting the last two interfere with the normal operations of its advisory business.

In general during the time of the SEC action, a material change in any product on Merrill’s advisory platforms, such as replacing the product’s portfolio manager, results in Merrill’s Due Diligence team conducting an in-depth review of the product. If they give it a thumbs down, the analysts put together a termination recommendation. It eventually ends up with Merrill’s Governance Committee for the ultimate decision. The Governance Committee had apparently always approved termination recommendations.

In 2012 one of the products in platform managed by a U.S. subsidiary of a foreign multinational bank announced a change in portfolio manager. It was a big change. The product was run by a single portfolio manager with accounts having a minimum of $100,000 invested in portfolios of 20-25 bonds specifically selected by the portfolio manager. The new manager was a team that had been responsible for institutional accounts with a minimum of $100 million invested in diversified portfolios of approximately 150 bonds.

That was a big change and had no track record for the new investing style. It seems like an easy termination and due diligence recommended the termination.

The problem is that a Merrill employee contacted the platform before the Governance Committee vote. The employee was trying to get in front of the operational issues from inevitable termination.

But that proactive communication gave the platform time to lobby Merrill management for a reconsideration. Apparently, that also included discussion of a possible active bookrunner role in a registered offering associated with the platform. Senior management apparently intervened in the termination process.

The most unusual part was the person who ran the agenda for Merrill’s Governance Committee got an email from a platform employee telling the Merrill person that the item was going to removed from the agenda.

The Due Diligence Employee received this email on the morning of January 16 and forwarded the email to another Merrill executive, stating, “Here is a first. An external manager telling an internal product staffer what can go on an internal governance agenda” to which the recipient responded, “[A]stonishing.”

The Governance Committee did not vote on the termination and instead diligence went back for more review.

Merrill ended up with non-active bookrunner rule in the offering, getting a smaller allocation.

Ultimately, the product stayed on hold for a year. The performance was satisfactory. It performed as well and in some instances better than the products that would have replaced it.

Investors were not harmed, but Merrill had a breakdown in procedure. It’s decision-making was clearly in conflict. The SEC came down hard, forcing Merrill to disgorge the fees it earned on the platform over the year and pay an equivalent fine.

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Quarterly Reporting or Semi-Annual Reporting

According to a tweet from President Trump, he asked the Securities and Exchange Commission to study the possibility of moving from quarterly to semi-annual reporting for public companies.

In speaking with some of the world’s top business leaders I asked what it is that would make business (jobs) even better in the U.S. “Stop quarterly reporting & go to a six month system,” said one. That would allow greater flexibility & save money. I have asked the SEC to study!

— Donald J. Trump (@realDonaldTrump) August 17, 2018

From a compliance perspective, the issue is more about quarterly guidance, than quarterly reporting.

The broader argument is about short-term focus on reported numbers than the long term focus of the company. I’m not sure that would work out that way or change things. There are many people smarter than me that have written detailed research papers on the topic. They don’t seem to have reached a conclusion.

According to a story in Wall Street Journal, the impetus of Trump’s tweet was a meeting with outgoing PepsiCo CEO Indra Nooyi. During a dinner with the President, he asked “What can we do to make it even better?” According to the Wall Street Journal: “she said, ‘Two-time-a-year reporting, not quarterly.’”

Will companies switch if you make the regulatory change?

Probably not.

The European Union made this change in 2014. Less than 10% of UK companies switched from quarterly to semi-annual.

Institutional investors report their results quarterly and expect their underlying investments to report quarterly. Companies would need to convince shareholders to accept less frequent reporting.

The other aspect is contractual obligations for quarterly reporting. Most companies have a obligations to their lenders for quarterly reporting. That would not go away just because of the regulatory change.

Then there is the question of whether President Trump’s tweet amounts to an official action by the White House. We seem to have a mixed message form some sources as to whether its an official order or not.

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Stop the Fraud with a PAUSE

A new program from the Securities and Exchange Commission will always (hopefully) catch my attention. I paused for a minute when I saw a press release for the SEC’s update of PAUSE, the “List of Firms Using Inaccurate Information to Solicit Investors.” That sounded interesting. The list even had a catchy acronym. PAUSE stands for Public Alert: Unregistered Soliciting Entities.

For me, interesting turned into a groan, like hearing a bad pun.

Bad acronym aside, I applaud any program that makes investors more aware of bad people trying to take their money away.

The PAUSE list comes from consumer complaints about firms claiming to be registered with the SEC, but are not. Feel free to browse through the list. I found dead links on the first few I tried to check out.

In addition to the PAUSE list, there is also Impersonators of Genuine Firms. This is a list of entities that use a name that is the same as, or similar to, the name of a US registered securities firm, notwithstanding the fact that the soliciting persons are not affiliated with a US registered securities firm. The SEC provides some detail to distinguish the fake firms from the registered firms.

My favorite additional list was the one of Fictitious Regulators. This is a list of entities that claim an endorsement, approval or other support by a governmental agency or international organization that does not exist or does not really lend support to the entity or the investments it is offering. Most of the websites for these scam agencies are dead.

Going back to the original press release, it used the word “update.” That meant PAUSE was not new. It was first created in 2007. (Release Nos. 34-56534 ; IA-2658 ; File No. S7-24-07)

In light of the challenges associated with taking enforcement action against such operations, the Commission believes that it is useful to devise a complementary approach that serves to empower prospective investors. The goal of the PAUSE Program is to provide prospective investors with relevant information about unregistered soliciting entities before they invest.

I don’t remember hearing much about PAUSE in the last 11 years.

 

Not Understanding the Meaning of “supervised release”

Howard M. Appel is a bad guy who has been convicted of securities fraud multiple times. This time it was for actions in 2010 through 2013. He secretly acquiring large blocks of stock in three publicly traded companies and then manipulated the market for those shares with co-conspirators. It was classic pump and dump schemes.

He assembled a team of associates to hold shares on his behalf. He created liquidity by conducting matched trades, increasing the volume of trades but with no economic effect. Then the associates would start raising the trading price through their trading activity. Meanwhile, Appel would convince 3rd parties to buy the stock with the story of its rising price. Then he would have his associates sell the stock for a big profit. As he walked away, the stock price would crash.

What caught my attention in this case was Appel’s criminal history. He was in jail from June 2008 to June 2010 for conspiracy and money laundering in connection with a previous pump an dump scheme. He was on supervised release from June 2010 until June 2013.

He was running the new pump and dump schemes while under supervised release.

Clearly, more supervision was need.

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The One With Cross-Fund Transactions

United Development Funding and its investment platforms have been under attack for a few years. It looks it has finally come to grips with its mistakes. UDF is closing out investigations into its funding of real estate investments from multiple investment platforms.

The attacks started in 2015 when Kyle Bass, who runs Dallas-based hedge fund Hayman Capital Management LP, bet against UDF IV shares and publicly raised questions about UDF. Bass called the company a billion-dollar house of cards and a Ponzi Scheme, using newly raised capital to pay off old investors. Bass detailed projects that were funded for more than a decade without any noticeable development, projects without impairments being recorded and loans being paid off without an obvious cash flow.

Bass noticed the October 2014 that the UDF III partnership, a non-traded, publicly registered REIT announced that it had formed a special committee comprised of independent advisors to evaluate potential strategic alternatives.

Then in February 2016, the FBI raided the offices of UDF. There were internal investigations, a threatened delisting by NASDAQ and an SEC investigation. The SEC just announced settlement of its case.

So what happened?

UDF III had loans to developments were stalled and the developers lacked capital re-pay the loans. UDF IV fund loaned money to developers who had also borrowed money from UDF III. Rather than using those funds for development projects that were underwritten by UDF IV, UDF directed the developers to use the loaned money to pay down their older loans from UDF III. Even worse, in some instances, the developer never received the borrowed funds at all, and UDF simply transferred the money between funds so that UDF III could make the distributions to its investors.

This is an example of the dangers posed by transactions between investment platforms. It looks like a Ponzi scheme. The additional problem was the lack of disclosure, the failure to right down the UDF III loans and UDF IV’s improper treatment of its capital deployment.

The investigations do not point to fraud in that UDF or its executives were pocketing the cash improperly. Certainly the fundraising for UDF IV would have been less successful if investors knew the capital was in part being used to fund investments by UDF III.

What UDF did with funding would not have been a problem if it has disclosed the information. Instead UDF hid the problem by not fully disclosing the inter-platform transactions and not writing down the value of the UDF III investments.

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Continuing Lucia

After last week’s Supreme Court decision in Lucia v. Securities and Exchange Commission, it’s clear that administrative law judges of the US Securities and Exchange Commission are not mere federal employees but qualify as “Officers of the United States” under the Appointments Clause of the US Constitution. That means they need be appointed by the president, courts of law, or heads of departments, in this case the SEC Commissioners.

It’s also clear that Mr. Lucia’s victory is hollow. The remedy in the decision was that Mr. Lucia was entitled to a new hearing by new administrative law judge who had been properly appointed. In December the SEC Commissioners ratified the appointment of the ALJs. That was done in anticipation of this decision. I assume that is enough to meet the requirements of the Appointments Clause. I expect that may also be challenged by Mr. Lucia if he case starts over.

There is still lots of uncertainty after the Lucia decision. Enough uncertainty that the SEC has halted all administrative proceedings for 30 days.

The Lucia decision required that the case be heard before a new ALJ. At a minimum,  the SEC is going to do a lot of shuffling of cases from ALJ to another for any case started before December. It may also decide to shift the cases over to federal courts. According to one estimate there are 100+ cases involved.

One big unanswered question is whether the SEC ALJ proceedings are the proper venue. Dodd-Frank expanded the use of administrative proceedings. Under Chair White, the SEC increased its use of administrative proceedings instead of federal court. Under Chair Clayton, the SEC seems to be increasing using federal courts instead of the administrative proceedings. This was one of the points raised in Justice Breyer’s concurring opinion in Lucia.

I expect we will hear some news from the SEC during this 30-day halt on how they are going to proceed with ALJs.

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The SEC’s Administrative Law Judges are “Officers of the United States”

The Supreme Court issued its decision in Lucia v. Securities and Exchange Commission.  The problem is that the administrative law judges were appointed by an internal panel instead of by the President or the SEC Commissioners. The Appointments Clause of the Constitution is there to make sure that those who wield power are subject to “political force and the will of the people.” The President appoints “Officers” who are those who exercise “significant authority pursuant to the laws of the United States.”

Radio personality Raymond J. Lucia, Sr. got in trouble with the SEC by claiming that his “Buckets of Money” strategy had been successfully backtested when in fact it had not been. Lucia was a registered investment advisor, but the SEC barred him for his transgressions. He appealed.

The Supreme Court re-affirmed a three prong test to determine if an official is an “Officer” under the Appointments Clause:

  1. Holds a continuing office established by law
  2. Exercises significant discretion when carrying out the functions of that office
  3. Issues decisions with finality

The majority opinion found all three of these to be true with the SEC’s ALJs.

The concurring opinion of Justices Thomas and Gorsuch though that the determination of an “officer” merely has to answer the first prong, proposing a much broader definition of an “officer.” The dissent by Justices Sotomayor and Ginsburg felt the finality part of the third prong was not true for the SEC’s ALJs because the SEC can overrule the decision.

What is the impact of the decision?

For Mr. Lucia, it means he is entitled to a new hearing with a different ALJ. The Supreme Court explicitly stated that Mr. Lucia is entitled to a new hearing with a different ALJ who is properly appointed.

I believe all of the SEC’s ALJs are now properly appointed directly by the SEC. In December, the SEC changed its process in anticipation of this decision. The Solicitor General had decided to agree with the argument of Mr. Lucia that the ALJs are “officers.”

The unanswered question is what happens to those cases decided by ALJs. I suppose there could be many others with adverse findings who are going to ask for new hearings with a different ALJ.

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